Professional Documents
Culture Documents
September15,2011
NikunjKapadia1andEdwardSzado2,CFA
CISDMgratefullyacknowledgesresearchsupportprovidedbytheOptionsIndustryCouncil.
Researchresults,however,representthoseoftheauthorsanddonotnecessarilyrepresentthe
viewsoftheOIC.WethankPhilGockeforcommentsandsuggestions.Pleaseaddress
correspondencetoEdwardSzado,CISDM,UniversityofMassachusetts,Amherst,MA01003,
4135773166,oremail:ed@cisdm.org.
AssociateProfessorofFinance,IsenbergSchoolofManagement,UniversityofMassachusetts,Amherst,MA
01003.
2
ResearchAssociate,CISDM,IsenbergSchoolofManagement,UniversityofMassachusetts,Amherst,MA01003.
Abstract
UsingdatafromJanuary18,1996toMarch31,2011,weconstructandevaluatereturnsona
buywritestrategyontheRussell2000index.Theresultsdemonstratethatthestrategyhas
consistentlyoutperformedtheRussell2000indexonariskadjustedbasis,whenimplemented
withonemonthtoexpirationcallsandwhenperformanceisevaluatedusingstandard
performancemeasures.Overthe182monthperiodofanalysis,theRUTbuywritestrategy
using2%outofthemoney,onemonthcallsgeneratedhigherreturnsthantheunderlying
index(8.87%versus8.11%)ataboutthreequartersofthestandarddeviation(16.57%versus
21.06%).Theoutperformanceisrobusttomeasureswhichspecificallyconsiderthenonnormal
distributionofthestrategy'sreturns.However,theconsistentperformanceadvantagedoesnot
remainifweutilizetwomonthtoexpirationcalls.Toevaluatetheperformanceinvarying
marketconditions,webreakoursampleintosubperiods.Specifically,oneoftheworstmarket
conditionsforthebuywritestrategyisMarch2003toOctober2007,whentheRussell2000
experiencesahighsustainedgrowthatarelativelylowvolatility.Eveninthismarket
environment,wefindthatthe2%outofthemoneyonemonthbuywritestrategy
outperformstheRussell2000onariskadjustedbasis,returningalmostthesamereturnsasthe
indexreturnatthreequartersitsvolatility.Weprovideinsightintothesourcesofthe
performance.Onaverage,theexpirationvalueofwrittencallsexceedsthepremiumcollected
andthetransactioncostsofwritingthecallatthebidfurtherincreasesthelosses.However,
thebuywritestrategybenefitsbywritingcallsatanimpliedvolatilitythatisgenerallyhigher
thantherealizedvolatility.Infact,wefindthatthecontributionofthevolatilityriskpremium
thedifferencebetweenimpliedandrealizedvolatilityistypicallylargerthanthenetlosses
incurredbythecallpositionorthetransactioncosts.Itappearsthattheexistenceoftherisk
premiumiscriticaltotheperformanceofthestrategy.Infact,the(Leland's)alphaofthe
strategyistypicallysignificantlysmallerthantheriskpremiumimplyingthatthebuywrite
strategywouldnotprovideexcessreturnsintheabsenceoftheriskpremium.
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Introduction
ThepurposeofthisstudyistoupdatetheresultsofKapadiaandSzado[2007],TheRiskand
ReturnCharacteristicsoftheBuywriteStrategyontheRussell2000Indextoinclude
performancethroughtherecentfinancialcrisis3.Theinitialstudyincludedapproximately10
yearsofdatafromJanuary19,1996throughNovember17,2006.Thisnewstudyaddsalmost
fiveyearsofdata,extendingtheanalysisthroughMarch31,20114.
Thepurposeofthispaperistoassesstheriskandreturncharacteristicsofabuywrite(covered
call)strategyontheRussell20005.Theequityindexbuywritestrategyentailsthewritingofa
callonanequityindexagainstalongpositioninthecorrespondingunderlyingequityindex.A
buywriteisutilizedasareturnenhancementstrategy,althoughtheextracashflowfromcall
writingdoesproducesomeriskmitigationbyprovidingacushionagainstlossesinthe
underlying.Typically,thebuywritestrategywouldbeimplementedpassively,without
attemptingtotimethemarket.Theoriginalpaper(KapadiaandSzado[2007])wasmotivated
bythegrowinginterestintheuseofbuywritestrategiesforinvestmentpurposes.Theinterest
wasreflectedinCBOEsintroductionofanumberofbuywriteindicesbasedonavarietyof
equityindicessuchastheS&P500,theDowJonesIndustrialAverage,theNASDAQ100andthe
Russell2000.Althoughanumberofpapershaveexaminedthereturnsonthestrategyforthe
S&P5006,theriskandreturncharacteristicsofthebuywritestrategyontheRussell2000has
notbeenextensivelyexamined.Previousstudieshaveconsistentlyfoundthatthebuywrite
strategyontheS&P500outperformedtheS&P500onariskadjustedbasispriortothe
financialcrisis.Itiscertainlyworthwhiletodeterminewhethertheresultsassociatedwiththe
earlierpapersarerobustacrossotherindicesandacrossvaryingmarketconditions,including
thefinancialcrisis.Thefinancialcrisishasprovidedabackdropfortestingthestrategyin
particularlyturbulenttimes.Moregenerally,theanalysisofthereturnsofthebuywrite
strategyalsoallowsusinsightintohowoptionsarepricedandtradedinthemarket.Ifthe
assumptionsunderlyingtheBlackScholesanalysisheldprecisely,itwouldbestraightforwardto
understandthereturnsofabuywritestrategy.Inpractice,however,thereturnsareimpacted
bybothtransactioncostsandtheactualmarketvalueoftheoptions,whichtendstobehigher
thanthepricessuggestedbytheBlackScholesformula.Thispricedifferentialmanifestsitselfin
Itisworthnotingthattheresultsinthispapervarysomewhatfromtheoriginalpaperduetosubsequentdata
cleaningbyOptionmetricsandsomesmallchangesinmethodologyoutlinedinthebodyofthepaper.
4
TheanalysisisbasedonmonthlyreturnsfortheperiodofFebruary1,1996toMarch31,2011.
5
TheRussell2000(RUT)wasutilizedfortheoriginalstudyratherthanthemoreeasilyinvestableiSharesRussell
2000Indexexchangetradedfund(IWM)duetothemuchlongeravailabletimeseriesoftheRUT.
6
SeeWhaley(2002),FeldmanandRoy(2004),RenickerandMallick(2005),andHilletal(2006).
3|P a g e
impliedvolatilitiesthatareconsistentlyhigherthanrealizedhistoricalvolatilities7.Ourobjective
istousetheanalysisofthebuywritestrategytoprovideinsightintotheeconomicimportance
ofthesepotentiallyoffsettingeffects.Whiletheoriginalstudyprovidedacomprehensive
analysisofthebuywritestrategyfortheRussell2000overtheperiodfromJanuary19,1996to
November17,2006,thisupdateextendstheanalysisthroughtoMarch31,2011.Thelengthof
thesampleperiodallowsustoassesstheperformanceindifferentmarketconditions.In
addition,weprovideacomparisonofthestrategyoverarangeofimplementationswith
differingcallstrikesandmaturities.Consistentwiththepreviousliterature,wefindthatthe
buywritestrategymayoutperformtheindex.However,theperformancedependsonthe
optionselectioncriteriaoftheparticularimplementation.Wefindthattheonemonthtwo
percentOTMstrategyoutperformstheindexusingavarietyofmeasures.Overthe182month
periodofanalysis,theRUTbuywritestrategyusing2%OTM,onemonthcallsgenerateda
higherreturnthantheunderlyingindex(8.87%versus8.11%)ataboutthreequartersofthe
standarddeviation(16.57%versus21.06%).Moresignificantly,itoutperformstheindexin
possiblytheworstmarketenvironmentforthestrategy,whentheindexexperienceslarge
sustainedpositivereturnswithlowvolatility.Overthe56monthperiodfromMarch2003to
October2007,theRussell2000hadanannualizedreturnof20.92%andavolatilityof14.08%.
Eveninthisunfavorablemarketenvironment,the2%OTMbuywritestrategyreturnedalmost
thesamereturnastheRussell2000atabouttwothirdsthelatter'svolatility,easily
outperformingthemarketbystandardmeasures.Asmentionedearlier,theselectioncriteria
forthecallsareimportantindeterminingthestrategy'sreturns.Thisisthecasebecauseboth
transactioncostsandthevolatilityriskpremium(thepremiumofimpliedvolatilityoverrealized
volatility)haveasignificantimpactonreturns,andthemagnitudeofboththesefactorsvaries
significantlyacrossoptionswithdifferingmoneynessandtimetoexpiration.Infact,therisk
premiumofthecalliscriticaltothereturnsofthestrategyasourresultssuggestthatthe
strategywouldnotoutperformtheindexifoptionswerepricedatrealizedvolatility.Overall,
wefindthatthebuywritestrategycanoutperformtheunderlyingindex.However,both
transactioncostsandthechoiceoftheoptioncontractarecentralfactorsindeterminingthe
performance.
DataandMethodology
Forthisupdateandfortheoriginalstudy,weutilizedoptiondatafromOptionmetrics.The
datasetcomprisesofclosingbidsandoffersofalloptionsandindicesquotedacrossallthe
exchangesfortheperiodfromJanuary1996throughMarch2011.TheOptionmetricsdataalso
providesuswithcomputedimpliedvolatilities.ThereturnsontheRussell2000arecombined
ThemeasureddifferentialassumesthedistributionalassumptionsoftheBlackScholesmodel.Impliedvolatilities
aremeasuredbasedontheBlackScholesmodel.Iflognormalitydoesnothold,bothrealizedandimplied
volatilitiesmaysufferfrommeasurementerrors.
4|P a g e
withadailycashdividendtocreateatotalreturnindex.ThedailytotalreturnoftheRussell
2000indexiscalculatedas:
Dailydataisutilizedtoallowustocreatedailybuywritestrategyreturns.Whiletheoriginal
studycalculatedmonthlyreturnsfromexpirationtoexpiration,thisupdatecalculatesmonthly
returnsfrommonthendtomonthendtomorecloselymatchthetypicalfocusofinvestors.The
Russell2000totalreturnindex,combinedwiththereturnsoftheshortcallpositions,
determinesthereturnsofourbuywritestrategy.Fortheanalysis,weconstructabuywrite
index,closelyfollowingthemethodologyinWhaley(2002).TheCBOEindicesarealsobasedon
asimilarmethodology.Detailsoftheindexconstructionareasfollows:Onceeachmonth,at
thecloseonthedaybeforetheexpiringoptionsettles(usuallythethirdThursdayofthe
month),anewcalliswritten.
Onthebusinessdayfollowingthedayanewcalliswritten8,thebuywritereturniscalculated
as:
Onthedayanewcalliswritten(andanoldcallpositionisclosed),thebuywritereturnis
calculatedas:
Onallotherdays,thebuywritereturniscalculatedas:
Inordertoperformtheanalysisonmonthlydata,monthlyreturnseriesareconstructedfrom
thedailyreturnseriesforeachbuywriteimplementation.
Wecompareseveraldifferentimplementationsoftheindex.First,foreachmaturity,we
construct5indicescorrespondingtotheatthemoney(ATM)aswellas2%and5%inthe
money(ITM)callsandoutofthemoneycalls(OTM),respectively.Weusetwodifferent
maturities,onemonthandtwomonth,sothatwehaveatotalof10indices.Themainbodyof
thepaperincludestheresultsfortheonemonthstrategies.Theresultsforthetwomonth
implementationsareprovidedintheappendix.Forallstrategies,theoptionishelduntil
Inordertocapturetransactioncosts,wewritethenewcallatthebidprice.
5|P a g e
expiration9.Theshortcallpositionisclosedattheintrinsicvalueofthecall.Thereisaslight
inaccuracyimposedbythisprocedure.Althoughinpractice,thecallissettledbasedonthe
Russell2000componenttradepricesonthemorningofthedaybeforeexpiration,weare
effectivelysettlingtheoptionsbasedontheclosingpricesofthepreviousday.Wedothis
becauseouroptionsdatasetdoesnotincludeopeningprices.Inordertoincludea
representationoftransactioncosts,thenewcalliswrittenatthecurrentbid.Foralldays
betweentherollindateforthenewcallandtherollout(expiration)ofthecall,thecallis
markedtomarketforreturncalculationsatthemidpointbetweenthebidandtheask.In
performingouranalysis,wefaceadatalimitationinthatbidaskquotesacrossallstrikesare
notavailableovertheentireperiod(althoughthedataavailabilityimprovessignificantlyin
morerecentyears).Toensurethattheindexisrepresentativeofactualcloseandbidask
prices,weonlyuseoptionswhichhaveafullsetofbidaskclosepricesavailableovertheir
holdingperiod.Itisworthnotingthatthisputsagreaterrestrictionontheavailabledatathan
theoriginalstudyinwhichweonlyrequirepricesonrolldates.
Sinceoptionstrikepricesarenotcontinuous,theavailablestrikesarenotexpectedtoexactly
matchthedesiredmoneyness.Whenaspecificoptionquoteisnotavailable,wesubstituteit
withtheoptionofthenearestavailablestrike10.Exhibit1aprovidesdetailsoftheaverage
deviationfromthedesiredstrike,bothasapercentageoftheunderlyinglevelandonan
absolutebasis.
Exhibit1a:DeviationofUtilizedStrikesfromCalculatedStrikes
1MonthCallBuyWrite
5%OTM 2%OTM
ATM
2%ITM
5%ITM
Overall
AveragePercentage
Deviation
0.30%
0.03%
0.01%
0.03%
0.14%
0.03%
AverageDeviation
1.35
0.14
0.14
0.06
0.52
0.23
ATM
2%ITM
5%ITM
Overall
2MonthCallBuyWrite
5%OTM 2%OTM
AveragePercentage
Deviation
0.28%
0.05%
0.04%
0.04%
0.21%
0.02%
AverageDeviation
1.36
0.16
0.31
0.45
0.75
0.24
Morespecifically,thecallpositionisclosedattheclosepriceontheafternoonbeforethemorningexpiration
settlement.
10
Intheoriginalstudy,foroutofthemoneycalls,wesubstitutedthenextavailablestriketowardstheatthe
money.FortheATMcalls,weusedtheclosestavailablestrike.
6|P a g e
Onaverage,acrossalltheonemonthindicesweconstruct,theaveragepercentagedeviation
was0.03%fromthedesiredstrike(seeExhibit1a).However,themagnitudeofdeviationfrom
thedesiredstrikevariesacrossthedifferentstrategyimplementationsandovertime.Exhibits
1band1cprovidethetimeseriesofthedeviationsovertheperiodofanalysisfortheone
monthandtwomonthstrategies,respectively.TheonemonthATMstrategyisthemostpure
ofthebuywritestrategiesweconsider,withameandeviationfromthedesiredstrikeof0.01%
oftheunderlying.Itisworthnotingthatthedeviationsfromthedesiredstrikesarearesultof
discretestrikesaswellasdatalimitations.Quotesarenotalwaysavailablefortheallofthe
actualdiscretestrikesresultingintheuseoftheclosestavailablestrike.Inapractical
applicationofthesestrategies,onewouldnotencounterthesequoteavailabilitylimitations.
Thestrategycouldbeimplementedatthediscretestrikenearestthecalculatedstrike,sincethe
marketwouldprovidetherequiredquotes.
Thereturnsofthestrategywillbeimpactedbybothtransactioncostsaswellasanyconsistent
deviationoftheimpliedvolatilityfromthehistoricalrealizedvolatility.Theprimarytransaction
costassociatedwiththeimplementationofthestrategyisthebidaskspreadoftheoption.To
understandtheimpactofthebidaskspreadaswellastoallowforthepossibilitythatacall
maybewrittenwithinthespread,wecalculatethereturnsusingtwodifferentprocedures.In
thefirst,weassumethecallsarewrittenatthebid.Inthesecondweassumethecallsare
writtenatthemidpointbetweenthebidandask.
7|P a g e
Jan96
8|P a g e
Mo205%OTM
Mo202%OTM
Mo20ATM
Mo202%ITM
Mo205%ITM
Jan11
Aug10
Mar10
Oct09
May09
Dec08
Jul08
Feb08
Mo102%ITM
Sep07
Apr07
Nov06
Jun06
Jan06
Aug05
Mo10ATM
Mar05
Oct04
May04
Dec03
Jul03
Mo102%OTM
Feb03
Sep02
Apr02
Nov01
Jun01
Jan01
Aug00
Mo105%OTM
Mar00
Oct99
May99
Dec98
Jul98
Feb98
Sep97
Apr97
Nov96
Jun96
InitialPercentITM
Jan96
Jan11
Aug10
Mar10
Oct09
May09
Dec08
Jul08
Feb08
Sep07
Apr07
Nov06
Jun06
Jan06
Aug05
Mar05
Oct04
May04
Dec03
Jul03
Feb03
Sep02
Apr02
Nov01
Jun01
Jan01
Aug00
Mar00
Oct99
May99
Dec98
Feb98
Jul98
Sep97
Apr97
Nov96
Jun96
InitialPercentITM
Exhibit1b:TimeSeriesofInitialMoneynessofUtilizedStrikes,OneMonthCalls
InitialMoneynessbyTargetMoneyness:1MonthCalls
10.0
5.0
0.0
5.0
10.0
15.0
Mo105%ITM
Exhibit1c:TimeSeriesofInitialMoneynessofUtilizedStrikes,TwoMonthCalls
8.0
InitialMoneynessbyTargetMoneyness:2MonthCalls
6.0
4.0
2.0
0.0
2.0
4.0
6.0
8.0
Exhibit2:Growthof$100inthe1Month2%OTMBuywriteStrategy,ConsideringDifferent
TreatmentsofTransactionsCosts
1Month2%OTMBuyWriteGrowthof$100
$450
$400
$350
$300
$250
$200
$150
RUTTR
BuyWrite(SellatBid)
Feb11
Aug10
Feb10
Feb09
Aug09
Feb08
Aug08
Feb07
Aug07
Feb06
Aug06
Feb05
Aug05
Feb04
Aug04
Feb03
Aug03
Feb02
Aug02
Aug01
Feb01
Feb00
Aug00
Aug99
Feb99
Feb98
Aug98
Feb97
Aug97
Feb96
Aug96
$100
BuyWrite(SellatMidofBid/Ask)
Exhibit2providesagraphicalpresentationofthecumulativeimpactofthedifferencebetween
thesetwotreatmentsforthe1month2%OTMbuywritestrategy.ItisevidentfromExhibit2
thatifwedisregardtransactioncosts,thecumulativegrowthoftheATMbuywritestrategy
overthe15yearsofourstudyfarsurpassesthatoftheRussell2000,withlessvolatility.The
significanceoftheimpactoftransactioncostsisalsoquiteclear.Exhibits3aand3bprovide
detailsonthemagnitudeoftransactionscostsasapercentageoftheunderlyingprice.
Exhibit3a:BidaskSpreadsandVolatilityDifferentials
9|P a g e
AverageBid/AskSpread(as%ofUnderlying)
5%OTM 2%OTM
ATM
2%ITM
5%ITM
1Month
0.12%
0.15%
0.19%
0.24%
0.30%
2Month
0.17%
0.23%
0.26%
0.31%
0.34%
AverageVolatilitySpread(ImpliedMinusRealized)
5%OTM 2%OTM
ATM
2%ITM
5%ITM
1Month
1.4%
2.5%
3.4%
4.6%
6.4%
2Month
1.5%
2.4%
3.4%
4.3%
5.6%
Exhibit3b:BidaskSpreadsas%ofUnderlyingLevelTimeSeries,1MonthBuywrite
Bid/AskSpreadas%ofUnderlying
0.90%
0.80%
Bid/AskSpread
0.70%
0.60%
0.50%
0.40%
0.30%
0.20%
0.10%
2/1/2011
9/1/2010
4/1/2010
6/1/2009
11/1/2009
1/1/2009
8/1/2008
3/1/2008
5/1/2007
10/1/2007
7/1/2006
12/1/2006
2/1/2006
9/1/2005
4/1/2005
6/1/2004
11/1/2004
1/1/2004
8/1/2003
3/1/2003
5/1/2002
10/1/2002
7/1/2001
12/1/2001
2/1/2001
9/1/2000
4/1/2000
6/1/1999
11/1/1999
1/1/1999
8/1/1998
3/1/1998
5/1/1997
10/1/1997
7/1/1996
12/1/1996
2/1/1996
0.00%
ExpirationDate
1Month5%OTM
1Month2%OTM
1MonthATM
Theaverageinitialbidaskspread11asapercentageoftheunderlyingpricefortheonemonth
strategiesrangefrom0.12%to0.30%,smallerforcallsthatarefurtherOTM.Thepercentage
spreadsforthetwomonthoptionsarehigherthanthosefortheonemonthoptions,ranging
from0.17%to0.34%.Thespreadsforthe2%OTMonemonthandtwomonthstrategies(the
mainoptionsofinterest)are0.15%and0.23%,respectively12.Toputthesenumbersin
11
Thebidaskspreadquotedonthedayonwhichthecallsarewritten.Thisdoesnotincludespreadson
subsequentdays.
12
WhiletheoriginalstudyfocusedontheATMstrategies,theupdatefocusesonthe2%OTMstrategiestobe
consistentwithotherliterature(seeforexample,SzadoandSchneeweis[2010]).
10|P a g e
perspective,a2%OTMonemonthbuywrite,wouldincurtransactionscostsofapproximately
0.9%peryear13ifthecallsarewrittenatthebidprice.
Exhibit3c:BidaskSpreadsas%ofUnderlyingLevelTimeSeries,2MonthBuywrite
Bid/AskSpreadas%ofUnderlying
1.20%
1.00%
Bid/AskSpread
0.80%
0.60%
0.40%
0.20%
2Month2%OTM
2MonthATM
2Month2%ITM
2Month5%ITM
3/1/2011
5/1/2010
10/1/2010
7/1/2009
12/1/2009
2/1/2009
9/1/2008
4/1/2008
6/1/2007
11/1/2007
1/1/2007
8/1/2006
3/1/2006
5/1/2005
10/1/2005
7/1/2004
12/1/2004
2/1/2004
9/1/2003
4/1/2003
6/1/2002
11/1/2002
1/1/2002
8/1/2001
3/1/2001
5/1/2000
2Month5%OTM
10/1/2000
7/1/1999
12/1/1999
2/1/1999
9/1/1998
4/1/1998
6/1/1997
11/1/1997
1/1/1997
8/1/1996
3/1/1996
0.00%
ThetimeseriesofthespreadsareprovidedinExhibits3band3c.Whilespreadshavedecreased
substantiallyovertime,theyexperiencedsignificantpositivespikesduringthefinancialcrisis.
Onewouldexpectthegeneraltrendtowardlowertransactioncostsaswellasthespikesin
transactioncostsduringthecrisistohavesignificantimpactsontheprofitabilityofthebuy
writestrategy.
AshasbeendocumentedintheliteratureforoptionsontheS&P500(forexample,seeBakshi
andKapadia[2003]),theBlackScholesimpliedvolatilityisconsistentlyhigherthanthehistorical
realizedvolatilityovertheremaininglifetimeoftheoption.Theaveragerealizedvolatilityrisk
premium(definedastheimpliedvolatilitylesstherealizedvolatility)is2.5%and2.4%forthe
2%OTMstrategiesfortheonemonthandtwomonthtimestoexpiration,respectively.Since
thisisoneofthedriversofthebuywritestrategyreturns,thevolatilityriskpremiumwouldbe
expectedtohelpprovideafavorableenvironmentfortheimplementationofthestrategy.
Whilethedifferentialbetweenimpliedvolatilityandrealizedvolatilityisgenerallypositive,as
Exhibit4aand4bindicate,therealizeddifferentialvariesconsiderablyovertimeandisattimes
significantlynegative.Thisisparticularlythecasewhenrealizedvolatilityexhibitssudden
upwardspikes.
13
ofthebidaskspreadforeachofthe12months=0.5*0.15%*12.
11|P a g e
Exhibit4a:RealizedVolatilityDifferentials,1MonthBuywrite
ImpliedVolatilitySpreadoverRealizedVolatility
100%
80%
60%
Volatility
40%
20%
0%
20%
40%
60%
2/1/2011
9/1/2010
4/1/2010
6/1/2009
11/1/2009
1/1/2009
8/1/2008
3/1/2008
5/1/2007
10/1/2007
7/1/2006
12/1/2006
2/1/2006
9/1/2005
4/1/2005
6/1/2004
11/1/2004
1/1/2004
8/1/2003
3/1/2003
5/1/2002
10/1/2002
7/1/2001
12/1/2001
2/1/2001
9/1/2000
4/1/2000
6/1/1999
11/1/1999
1/1/1999
8/1/1998
3/1/1998
5/1/1997
10/1/1997
7/1/1996
12/1/1996
2/1/1996
80%
ExpirationDate
RealizedVolatility
1Month5%OTM
1Month2%OTM
1MonthATM
1Month2%ITM
1Month5%ITM
Exhibit4b:RealizedVolatilityDifferentials,2MonthBuywrite
ImpliedVolatilitySpreadoverRealizedVolatility
100%
80%
60%
Volatility
40%
20%
0%
20%
40%
3/1/2011
5/1/2010
10/1/2010
12/1/2009
7/1/2009
2/1/2009
9/1/2008
4/1/2008
6/1/2007
11/1/2007
1/1/2007
8/1/2006
3/1/2006
5/1/2005
10/1/2005
12/1/2004
7/1/2004
2/1/2004
9/1/2003
4/1/2003
6/1/2002
11/1/2002
1/1/2002
8/1/2001
3/1/2001
5/1/2000
10/1/2000
12/1/1999
7/1/1999
2/1/1999
9/1/1998
4/1/1998
6/1/1997
11/1/1997
1/1/1997
8/1/1996
3/1/1996
60%
ExpirationDate
RealizedVolatility
2Month5%OTM
2Month2%OTM
2MonthATM
2Month2%ITM
2Month5%ITM
RiskandReturnCharacteristics
FullSampleResults
Exhibit5providessummarystatisticsfortheonemonthbuywritestrategyfortheentire
sampleperiodfromFebruary1,1996toMarch31,2011.Inaddition,Exhibit6providesa
graphicalpresentationoftheperformanceovertheperiod.Wereportbothannualizedreturns
andannualizedstandarddeviationsforeachstrategyimplementation.Asthereturnsonthe
12|P a g e
buywritestrategyarenotnormallydistributed14,wealsoreportthehighermomentsofthe
distributionincludingtheexcesskurtosisandtheskewness.Sincestandarddeviationmaynot
beaneffectivemeasureofriskfornonnormaldistributions,wereportalternativemeasures
suchastherangeoftherealizedreturndistributionandthemaximumdrawdownandrunup.
Tobeconsistentwithextantliterature,wereportstandardriskadjustedperformancemeasures
includingtheSharperatio,Treynorratio,andJensensalpha.Sincethesemeasuresarenot
robusttononnormalreturndistributions,wealsoreporttworobustriskadjustedperformance
measures:theStutzerindexandLelandsalpha.
Inwhatfollows,wewillfocusmostlyonthestrategyforthe2%OTMonemonthbuywrite
althoughwecontinuetoreportthenumbersforotherstrikes.Detailsforalltwomonth
strategiesareprovidedintheappendix.Theannualizedreturnforthe2%OTMonemonth
strategyoverthe182monthsofoursampleperiodis8.87%comparedtotheRussell2000
returnof8.11%.Itisofgreatinterestthatthevolatilityofthestrategyforthe2%OTMbuy
writeismuchlowerthanthatoftheindex.Theannualizedstandarddeviationforthe1month
2%OTMbuywritestrategyis16.57%comparedto21.06%fortheRussell2000.However,the
meanreturnandvolatilityarenotsufficienttocharacterizethedistributionofreturnssincethe
buywritestrategy'sreturndistributionwouldbenonnormaleveniftheunderlyingRussell
2000distributionwasnormal15.Thebuywritestrategy'sreturnsaresignificantlymorefat
tailedandnegativelyskewedthanthereturnsoftheindex.Theexcesskurtosisandthe
skewnessofthe2%OTMstrategyare3.49and1.40comparedwith0.81and0.56forthe
underlyingindex.
Giventhatthereturndistributionisnonnormal,itisparticularlyimportanttoconsider
measuresofriskotherthanvolatility.Exhibit5reportstheminimummonthlyreturnandthe
maximumdrawdownoverthefullperiod.Theworstmonthlyreturnforthe2%OTMstrategyis
18.69%,whichisbetterthantheworstmonthlyreturnof20.80%fortheRussell2000.The
largestdrawdownforthe2%OTMstrategyis42.9%,comparedwiththemaximumdrawdown
of52.9%fortheindex.Conversely,thebestmonthlyreturnisfarhigherfortheindexat
16.51%,comparedwith9.68%forthe2%OTMstrategy.Incontrast,themaximumrunupis
lowerfortheindexat226.2%,comparedwith264.7%forthe2%OTMstrategy.These
measuressuggestthatthebuywritestrategyhadalowerrealizedriskoverthisperiodwhen
comparedtotheunderlyingindex.Thisargumentisfurthersupportedbythebuywrites
Lelandbetaof0.74.Fromariskadjustedperformanceperspective,theSharperatioand
Treynorratiosuggestthatthe2%OTMbuywriteoutperformedtheRussell2000overthe
14
Sincethebuywritestrategyessentiallytruncatestheupperendofthereturndistribution,onewouldexpectthe
returnstobenonnormal.
15
Fordetailsofthenonnormalityofthereturndistributionsseetheoriginalstudy.
13|P a g e
periodofstudy.TheSharperatiois0.33forthebuywriteand0.23fortheunderlyingindex.
Similarly,theTreynorratiosare0.08and0.05,respectively.
Exhibit5:1MonthBuywriteStrategySummaryStatistics,FullPeriod
1MonthCallBuyWrite Russell
Feb1,1996toMar31,2011
2000TR
AnnualizedReturn
AnnualizedStandardDeviation
Skewness
ExcessKurtosis
CorrelationwithRUT
SharpeRatio
TreynorRatio
StutzerIndex
CAPMBeta
Jensen'sMonthlyAlpha
Leland'sBeta
Leland'sMonthlyAlpha
MeanMonthlyReturn
MedianMonthlyReturn
MinimumMonthlyReturn
MaximumMonthlyReturn
MaximumDrawdown
MaximumRunUp
%DownMonths
%UpMonths
NumberofMonths
8.11%
21.06%
0.56
0.81
1.00
0.23
0.05
0.21
1.00
1.00
0.84%
1.68%
20.80%
16.51%
52.9%
226.2%
38%
62%
182
5%OTM 2%OTM
10.21%
18.63%
1.04
1.85
0.96
0.37
0.08
0.33
0.84
0.21%
0.86
0.20%
0.96%
1.74%
18.86%
10.57%
46.0%
337.1%
36%
64%
182
8.87%
16.57%
1.40
3.49
0.92
0.33
0.08
0.30
0.72
0.15%
0.74
0.14%
0.83%
1.77%
18.69%
9.68%
42.9%
264.7%
33%
67%
182
ATM
2%ITM
5%ITM
7.30%
14.66%
1.76
5.45
0.87
0.27
0.07
0.24
0.60
0.06%
0.63
0.05%
0.68%
1.62%
17.84%
10.16%
37.7%
193.0%
31%
69%
182
6.94%
13.24%
2.16
8.15
0.81
0.27
0.07
0.24
0.51
0.07%
0.53
0.06%
0.64%
1.33%
17.69%
10.01%
34.8%
178.0%
27%
73%
182
5.54%
10.99%
2.72
12.37
0.72
0.20
0.06
0.18
0.38
0.01%
0.40
0.00%
0.50%
0.91%
16.43%
8.26%
31.3%
130.7%
23%
77%
182
Asmentionedearlier,thesemeasuresarenotrobustagainstadeviationfromnormality.For
thisreason,LelandsalphaandtheStutzerindexarepresented.Theformerisarobust
alternativeforJensen'salphaandthelatterisanalternativefortheSharperatio.The2%OTM
buywriteexhibitedapositive0.15%monthlyLelandalphaovertheperiodofstudy(risk
adjustedperformanceabovetheRussell2000).Inaddition,theStutzerindexofthebuywriteis
significantlygreaterthanthatoftheRussell2000(0.30and0.21,respectively).
14|P a g e
Exhibit6:1MonthBuywriteStrategyGrowthof$100,FullPeriod
1MonthBuyWriteGrowthof$100
$500
$450
$400
$350
$300
$250
$200
$150
RUTTR
ATM
5%OTM
Feb11
Feb10
Aug10
Feb09
Aug09
Feb08
Aug08
Feb07
Aug07
Feb06
Aug06
Feb05
2%OTM
Aug05
Feb04
Aug04
Feb03
Aug03
Feb02
Aug02
Feb01
Aug01
Feb00
Aug00
Feb99
Aug99
Feb98
Aug98
Feb97
Aug97
Feb96
Aug96
$100
Exhibit7illustratesthe24monthrollingaverageannualizedreturnsofthe2%OTMbuywrite
strategy.WhiletheabsoluteperformancegapbetweenthebuywriteandtheRussell2000
fluctuatessignificantly,thegapisoftenextremelysmall.Incontrast,Exhibit8showsarelatively
consistent24monthrollingannualizedstandarddeviationgapbetweenthebuywriteandthe
Russell2000,withthe2%OTMbuywritetypicallyexhibitinga5to7%lowerrollingvolatility.
15|P a g e
16|P a g e
RUTTR
ATM
2%OTM
2%OTM
5%OTM
Apr09
Sep09
Feb10
Jul10
Dec10
ATM
Dec05
May06
Oct06
Mar07
Aug07
Jan08
Jun08
Nov08
RUTTR
Aug02
Jan03
Jun03
Nov03
Apr04
Sep04
Feb05
Jul05
Apr99
Sep99
Feb00
Jul00
Dec00
May01
Oct01
Mar02
Jan98
Jun98
Nov98
Jan98
Jun98
Nov98
Apr99
Sep99
Feb00
Jul00
Dec00
May01
Oct01
Mar02
Aug02
Jan03
Jun03
Nov03
Apr04
Sep04
Feb05
Jul05
Dec05
May06
Oct06
Mar07
Aug07
Jan08
Jun08
Nov08
Apr09
Sep09
Feb10
Jul10
Dec10
Exhibit7:24MonthRollingAnnualizedReturns
24MonthRollingAnnualizedReturn
60%
50%
40%
30%
20%
10%
0%
10%
20%
30%
40%
5%OTM
Exhibit8:24MonthRollingAnnualizedStandardDeviation
24MonthRollingAnnualizedStandardDeviation
35%
30%
25%
20%
15%
10%
5%
0%
Theperformanceofthebuywritestrategyissensitivetomarketconditions.Inparticular,we
expectthestrategytounderperformrelativetotheindexinastrongupwardtrendingmarket
whichconsistentlymovesthroughthestrikepriceofthewrittencallatlowvolatility.To
observetheimpactofvaryingmarketconditionsontheperformanceofthebuywrite,wesplit
theoveralldataperiodintothreesubperiods:February1,1996toFebruary28,2003;March1,
2003toOctober31,2007;andNovember1,2007toMarch31,2011.Thebreakpointswere
chosenspecificallytocapturethestrongandsteadyfourplusyearrunuptheRussell2000
experiencedfromitslocalminimuminMarch2003toitslocalprecrisismaximuminOctober
2007(ascanbeobservedinExhibit2)aswellasisolatingthefinancialcrisis.
Exhibit9:1MonthBuywriteStrategySummaryStatistics,FavorablePeriod
1MonthCallBuyWrite Russell
Feb1,1996toFeb28,2003
2000TR
AnnualizedReturn
AnnualizedStandardDeviation
Skewness
ExcessKurtosis
CorrelationwithRUT
SharpeRatio
TreynorRatio
StutzerIndex
InformationRatiowithRUT
CAPMBeta
Jensen'sMonthlyAlpha
Leland'sBeta
Leland'sMonthlyAlpha
MeanMonthlyReturn
MedianMonthlyReturn
MinimumMonthlyReturn
MaximumMonthlyReturn
MaximumDrawdown
MaximumRunUp
%DownMonths
%UpMonths
NumberofMonths
17|P a g e
3.28%
21.83%
0.39
0.50
1.00
0.06
0.01
0.06
1.00
1.00
0.47%
0.91%
19.42%
16.51%
35.1%
93.3%
44%
56%
85
5%OTM 2%OTM
6.07%
18.84%
0.88
1.40
0.96
0.08
0.02
0.07
0.29
0.83
0.19%
0.83
0.19%
0.64%
1.02%
18.86%
9.85%
29.3%
90.6%
44%
56%
85
5.49%
16.76%
1.28
2.75
0.92
0.05
0.01
0.05
0.09
0.71
0.12%
0.72
0.12%
0.57%
1.25%
18.38%
8.18%
28.9%
72.1%
38%
62%
85
ATM
2%ITM
5%ITM
4.40%
15.09%
1.57
4.07
0.89
0.02
0.00
0.01
0.07
0.61
0.02%
0.62
0.02%
0.46%
1.15%
17.31%
7.33%
26.7%
59.7%
34%
66%
85
5.22%
13.71%
1.89
5.77
0.83
0.04
0.01
0.04
0.03
0.52
0.08%
0.53
0.08%
0.51%
1.16%
16.59%
7.32%
23.5%
58.7%
33%
67%
85
3.95%
11.25%
2.34
8.64
0.77
0.06
0.02
0.06
0.15
0.40
0.04%
0.40
0.04%
0.38%
0.92%
14.20%
6.46%
17.7%
50.3%
27%
73%
85
BuywriteStrategyinFavorableMarketEnvironment
TheperiodfromFebruary1,1996toFebruary28,2003isasomewhatfavorableperiodforthe
buywrite(relativetotheunderlyingperformance).Thesecondhalfoftheperiodseems
particularlyfavorableforthebuywrite(relativetotheunderlying)sincetheunderlyingexhibits
adownwardtrendandagenerallyhighpositivespreadofimpliedvolatilityoverrealized
volatility(seeExhibit10).Duringthisperiod,theunderlyingexperiencedalowannualized
returnof3.28%atahighstandarddeviationof21.83(volatilitywasparticularlyhighinthe
secondhalfoftheperiodasshowninExhibit4a).Whiletheperiodincludessomestrongrun
ups,theyarenotnearlyasstrongandsustainedasinthesecond(unfavorable)periodorinthe
third(crisis)period.Exhibit9providessummarystatisticsforthebuywriteperformanceinthis
favorablemarketenvironment.
Asexpected,inthisperiod,the2%OTMbuywriteoutperformstheunderlyingindex.Thebuy
writegeneratesalmosttwicethereturn(5.49%versus3.28%)ataboutthreequartersthe
volatility(16.76%versus21.83%).The2%OTMbuywritesoutperformanceinthisperiodis
furtherconfirmedbytheStutzerindex(0.05versus0.06)andLelandsalpha(+0.12%).A
graphicalpresentationoftheperformanceoverthisperiodisprovidedinExhibit10.
Exhibit10:1MonthBuywriteStrategyGrowthof$100,FavorablePeriod
1MonthBuyWriteGrowthof$100
$200
$190
$180
$170
$160
$150
$140
$130
$120
$110
RUTTR
18|P a g e
ATM
2%OTM
5%OTM
Feb03
Aug02
Nov02
May02
Feb02
Aug01
Nov01
May01
Feb01
Aug00
Nov00
May00
Feb00
Aug99
Nov99
May99
Feb99
Aug98
Nov98
May98
Feb98
Aug97
Nov97
May97
Feb97
Aug96
Nov96
May96
Feb96
$100
Exhibit11:1MonthBuywriteStrategySummaryStatistics,UnfavorablePeriod
1MonthCallBuyWrite Russell
Mar1,2003toOct31,2007
2000TR
AnnualizedReturn
AnnualizedStandardDeviation
Skewness
ExcessKurtosis
CorrelationwithRUT
SharpeRatio
TreynorRatio
StutzerIndex
InformationRatiowithRUT
CAPMBeta
Jensen'sMonthlyAlpha
Leland'sBeta
Leland'sMonthlyAlpha
MeanMonthlyReturn
MedianMonthlyReturn
MinimumMonthlyReturn
MaximumMonthlyReturn
MaximumDrawdown
MaximumRunUp
%DownMonths
%UpMonths
NumberofMonths
20.92%
14.08%
0.05
0.09
1.00
1.27
0.18
1.09
1.00
1.00
1.68%
1.70%
6.84%
10.73%
10.8%
147.1%
30%
70%
56
5%OTM 2%OTM
21.86%
12.66%
0.30
0.07
0.95
1.48
0.22
1.31
0.11
0.85
0.25%
0.88
0.22%
1.73%
2.03%
6.39%
9.22%
9.1%
151.5%
25%
75%
56
19.63%
10.52%
0.23
0.59
0.89
1.58
0.25
1.41
0.26
0.66
0.34%
0.69
0.31%
1.55%
1.94%
5.21%
9.47%
7.5%
130.8%
23%
77%
56
ATM
2%ITM
5%ITM
15.79%
7.89%
0.64
1.69
0.81
1.61
0.28
1.42
0.59
0.45
0.34%
0.49
0.30%
1.25%
1.82%
4.74%
7.70%
5.1%
98.2%
21%
79%
56
13.17%
5.90%
0.95
2.65
0.69
1.71
0.36
1.48
0.72
0.28
0.38%
0.32
0.34%
1.05%
1.29%
4.14%
5.82%
4.1%
78.1%
16%
84%
56
9.57%
3.36%
1.45
4.76
0.48
1.94
0.58
1.61
0.87
0.11
0.34%
0.14
0.32%
0.77%
0.84%
3.12%
2.84%
3.1%
53.2%
11%
89%
56
BuywriteStrategyinUnfavorableMarketEnvironment
TheperiodfromMarch1,2003toOctober31,2007isperhapstheepitomeofanunfavorable
environmentfortheperformanceofabuywritestrategy(relativetotheperformanceofthe
underlyingindex)16.TheannualizedreturnfortheRussell2000overthis56monthperiodwas
20.92%.Incomparison,theannualizedreturnintheearlierperiodofFebruary1996toFebruary
2003is3.28%.Inaddition,therunupoccurswithlowvolatilitytheannualizedvolatilityinthe
March2003toOctober2007periodis14.08%comparedwith21.83%fortheearlierperiod.
Thus,focusingontheresultsfromMarch2003toOctober2007allowsustounderstandhow
badlythebuywritestrategyperformedrelativetotheindexinwhatonewouldexpecttobe
oneoftheleastfavorable56monthperiodsinourentiresampleperiod.Interestingly,evenin
16
ThisisparticularlythecaseforATMordeepITMbuywritestrategiesinwhichtheoptionsoftenexpireddeep
ITMduringtheperiodduetothesustainedrallyintheunderlying.
19|P a g e
thisunfavorablemarketenvironment,Exhibit11showsthatthe2%OTMbuywritestrategy
performscrediblywithanannualizedreturnof19.63%almostequalingthereturnoftheindex
(20.92%).Theannualizedvolatilityofthestrategywasonly10.52%comparedtotheRussell's
volatilityof14.08%.Inotherwords,thebuywritestrategyachievedalmostthesamereturnas
theindexatabouttwothirdstheindexvolatility.
Ofcourse,inthisenvironmentonewouldexpectthatanATMorITMbuywritewouldperform
significantlyworsethatanOTMstrategy.Infact,sincethemedianmonthlyreturnoftheRussell
2000(1.70%)overtheperiodisclosetothemoneynessofthe2%OTMcalls,adeeperOTM
strategymaybemoreappropriateforassessinganearworsecasescenario.However,even
theATMor5%ITMbuywritestrategiesoutperformedtheRussell2000onariskadjusted
basis,bysomemeasures.WhiletheabsolutereturnsoftheATMand5%ITMbuywrite
strategies(15.79%and9.57%,respectively)weremuchlowerthantheRussell2000(20.92%),
thebuywritestandarddeviationswerefarlower(7.89%and3.36%,respectively).Thus,the
ATMbuywritegeneratedtwothirdsofthereturnoftheRussell2000atabouthalfthe
volatilityandthe5%ITMbuywritegeneratedhalfthereturnoftheRussell2000atonefifthof
thestandarddeviation.TheriskadjustedoutperformanceisconfirmedbytheStutzerindex
(1.42and1.61,versus1.09fortheunderlying)andLelandsmonthlyalpha(positive0.30%and
0.32%,respectively).
Exhibit12:1MonthBuywriteStrategyGrowthof$100,UnfavorablePeriod
1MonthBuyWriteGrowthof$100
$260
$240
$220
$200
$180
$160
$140
$120
RUTTR
20|P a g e
ATM
2%OTM
5%OTM
Sep07
Jul07
May07
Jan07
Mar07
Nov06
Sep06
Jul06
May06
Mar06
Jan06
Nov05
Jul05
Sep05
May05
Mar05
Jan05
Sep04
Nov04
Jul04
May04
Mar04
Jan04
Nov03
Sep03
Jul03
May03
Mar03
$100
Exhibit13:1MonthBuywriteStrategySummaryStatistics,FinancialCrisisPeriod
1MonthCallBuyWrite Russell
Nov1,2007toMar31,2011
2000TR
AnnualizedReturn
AnnualizedStandardDeviation
Skewness
ExcessKurtosis
CorrelationwithRUT
SharpeRatio
TreynorRatio
StutzerIndex
InformationRatiowithRUT
CAPMBeta
Jensen'sMonthlyAlpha
Leland'sBeta
Leland'sMonthlyAlpha
MeanMonthlyReturn
MedianMonthlyReturn
MinimumMonthlyReturn
MaximumMonthlyReturn
MaximumDrawdown
MaximumRunUp
%DownMonths
%UpMonths
NumberofMonths
1.99%
26.78%
0.58
0.03
1.00
0.03
0.01
0.03
1.00
1.00
0.46%
3.01%
20.80%
15.46%
52.0%
123.0%
39%
61%
41
5%OTM 2%OTM
4.03%
24.30%
1.04
0.88
0.96
0.12
0.03
0.11
0.14
0.86
0.16%
0.88
0.16%
0.58%
3.10%
18.81%
10.57%
46.0%
112.0%
34%
66%
41
2.20%
22.07%
1.28
1.94
0.92
0.05
0.01
0.05
0.13
0.75
0.02%
0.77
0.01%
0.39%
2.21%
18.69%
9.68%
42.9%
89.5%
37%
63%
41
ATM
2%ITM
5%ITM
2.36%
20.02%
1.49
3.13
0.87
0.06
0.02
0.06
0.15
0.65
0.03%
0.67
0.03%
0.37%
1.74%
17.84%
10.16%
37.7%
75.0%
37%
63%
41
2.35%
18.60%
1.77
4.72
0.82
0.07
0.02
0.06
0.17
0.57
0.04%
0.59
0.03%
0.34%
1.60%
17.69%
10.01%
34.8%
60.9%
32%
68%
41
3.47%
16.23%
2.14
6.66
0.75
0.15
0.05
0.14
0.13
0.45
0.14%
0.48
0.13%
0.40%
1.04%
16.43%
8.26%
31.3%
52.1%
29%
71%
41
BuywriteStrategyduringtheFinancialCrisis
TheperiodfromNovember1,2007toMarch31,2011coversthefinancialcrisis.Inthisperiod,
theRussell2000exhibitedarapidandverysignificantlossinvaluefollowedbyastrong
recovery.Inaddition,theperiodalsoexhibitedlargespikesinrealizedandimpliedvolatilities.
Exhibit4aprovidesagraphicrepresentationoftheseverityofthespikesinrealizedvolatility.
PerhapsthesinglestatisticthatbestdefinestheimpactofthefinancialcrisisontheRussell
2000isthemaximumdrawdown.Overthe41monthsofthisperiod,theRussell2000
experiencedamaximumdrawdownof52.0%.Thiswassignificantlylargerthanthatofthe
previoustwoperiods(35.1%and10.8%,respectively).Insuchanenvironment,onewould
expecttheextraincomethatcallwritinggeneratesmayhavebenefitedperformanceby
providingacushiontothedrawdowns.However,thisbenefitismitigatedbythereduced
21|P a g e
participationinthemarketrecovery(aswellasthesignificantincreaseexperiencedin
transactionscosts).Exhibits13and14suggestthatthebuywritestrategiesdidprovideasmall
degreeofreturnenhancementovertheperiodwithasignificantreductioninstandard
deviation.The2%OTMbuywritegenerateda2.20%annualizedreturn(1.99%forthe
underlying)atanannualizedstandarddeviationof22.07%(26.78%fortheunderlying).
Therefore,thebuywritegeneratedaslightlyhigherreturnatabout4/5thestandarddeviation.
Similarly,theStutzerindexwassomewhathigherforthebuywrite(0.05versus0.03)and
Lelandsmonthlyalphawaspositive0.01%forthebuywrite.Finally,maximumdrawdownwas
reducedfrom52.0%fortheunderlyingto42.9%forthebuywrite.Inthisperiod,the2%OTM
strategywastheworstperformingofthe1monthbuywritestrategies.Theother
implementationsoutperformedtheunderlyingbyafargreatermargin.
Exhibit14:1MonthBuywriteStrategyGrowthof$100,FinancialCrisisPeriod
1MonthBuyWriteGrowthof$100
$120
$110
$100
$90
$80
$70
$60
$50
RUTTR
22|P a g e
ATM
2%OTM
5%OTM
Mar11
Jan11
Nov10
Sep10
Jul10
May10
Mar10
Jan10
Nov09
Sep09
Jul09
May09
Mar09
Jan09
Nov08
Sep08
Jul08
May08
Mar08
Jan08
Nov07
$40
ReturnAttribution
Inordertobetterunderstandthedriversofreturns,webreakthebuywritereturnsdowninto
theirsourcecomponents17.Themostobvious(andmostsignificant)sourceofreturnsisthe
movementoftheunderlyingRussell2000index.Inadditiontothisobvioussource,weisolate
twootherfactorswhichcontributetothereturns.Aspreviouslymentioned,optionwritingis
subjecttosignificanttransactioncosts.Thesecostswerefoundtohaveasignificantnegative
impactonreturns.Ontheotherhand,optionwritingbenefitsfromthefactthatimplied
volatilitiesaretypicallyhigherthanhistoricalrealizedvolatilities.Thissectionofthepaper
focusesonunderstandingtherelativecontributionofthesetwofactorstotheperformanceof
thestrategy.WebeginbybreakingdownthebuywritestrategyreturnintotheRussell2000
returns,thetransactioncostreturnsandthecallreturns.Wethenfurtherdecomposethecall
returnintothereturnsattherealizedvolatility,thereturnsfromthevolatilityriskpremiumof
thecall,andonceagain,thetransactioncostreturns.Wefirstdecomposethebuywritereturn
intoitscomponents,expressingeachcomponentasapartialreturnonthetotalinvestmentin
thestrategy(longindex,shortcall).
Inthisframework,thebuywritereturnsconsistofthefollowing:
ThereturnsgeneratedbythelongpositionintheunderlyingRussell2000index;
thereturnsthatwouldbegeneratedbysellingthecallatthemidpointofthebidaskspread;
andthe(negative)returnsgeneratedbysellingthecallatthebid,ratherthanthemidpointof
thebidandask;
Thetotalreturnofthebuywriteindexisgivenas:
17
Forthepurposeofreturnattribution,wecalculatemonthlyreturnsfromexpirationtoexpirationratherthan
monthendtomonthend.
23|P a g e
Exhibit15:1MonthBuywriteStrategyReturnAttribution
BuyWriteReturnAttribution
February1996toMarch2011
1.4%
1.2%
1.0%
MonthlyReturn
0.8%
0.6%
0.4%
0.2%
0.0%
0.2%
0.4%
0.6%
5%OTM
2%OTM
ATM
Russell2000Return
CallReturn
2%ITM
5%ITM
Trans.CostReturn
Exhibit15illustratesthisreturndecomposition.WecanseethattheunderlyingRussell2000
indexisbyfarthemaincontributortotheoverallreturnsofthebuywritestrategy,averaging
closeto1%permonth.ItisworthwhiletonotethattheRussell2000returnsvaryslightlyfrom
strategytostrategyduetothedifferentcallpremiumsaffectingthenetinvestmentposition
eachmonth,andthereforethebasisbywhichthereturniscalculated.TheATMandITMone
monthstrategiespresentedinthechartexperienceanaveragebeforetransactioncostloss
fromthecallposition,typicallyaround0.2%permonth.Transactioncostshaveavery
significantcontributiontoreturns.Infact,aftertransactionscosts,thecallpositionsforall
strategiesexceptthe5%OTMgeneratealossfortheportfolio.Thelossduetotransaction
costsisgenerallyclosetothelossgeneratedbythecallpositionbeforetransactionscosts.
Wenowfurtherdecomposethecallreturns.
Thecallreturnsconsistofthefollowing:
ReturnsthatwouldbegeneratedifthecallshadbeensoldattheBlackScholesprice
associatedwiththerealizedvolatilityovertheholdingperiodofthecallposition;18
18
Forthesakeofclarity,weutilizethesamedenominatorintheattributionformulas.Ifastrategycouldbe
devisedthatcapturedonlyasinglecomponentofthereturnssuchassellingthecallsattheexpostrealized
volatility,thereturnbasis(denominator)wouldalsochangecorrespondingly.
24|P a g e
theextrareturnsthataregeneratedbysellingthecallattheBlackScholesimpliedvolatility
ratherthansellingattherealizedvolatility.Wereferredtothisdifferentialearlierasthe
volatilityriskpremiumofthecall.Thisisthedifferencebetweensellingatthemidpointofthe
bidaskspreadandsellingattheBlackScholespriceassociatedwiththerealizedvolatility.On
average,thiswouldrepresentthevolatilityriskpremium;
andthe(negative)returnsgeneratedbysellingthecallatthebid,ratherthanthemidpointof
thebidandask;
Thetotalreturnoftheshortcallpositionisgivenas:
Exhibit16:1MonthBuywriteStrategyShortCallReturnAttribution
CallOptionReturnAttribution
February1996toMarch2011
0.8%
0.6%
0.4%
MonthlyReturn
0.2%
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
5%OTM
2%OTM
MidBid/AskCallatRealizedVol.Return
ATM
Vol.Prem.Return
2%ITM
5%ITM
Trans.CostReturn
Exhibit16providesaclearillustrationoftheattributionofthecallreturns.Itisimmediately
evidentthatwiththeexceptionofthe5%OTMstrategy,thecallswouldgenerateasignificant
lossifsoldattheBlackScholespricesuggestedbytherealizedvolatility.Wecanseeanaverage
25|P a g e
monthlylossfortheseimplementationsofabout0.2%to0.8%attherealizedvolatility,without
evenincludingtransactioncosts.Itisinterestingthatthevolatilityriskpremiumofthecallis
reasonablycloseinmagnitudetothecalllossattherealizedvolatility.Infactwecanseethat
thereturngeneratedbytheriskpremiumofthecallgreatlyreducesthelossesofthecalls.For
example,the2%OTM1monthstrategy'scalllossesarealmostperfectlymatchedbytherisk
premiumgain.Thisreturnattributionanalysisillustratestheimportanceofthevolatilityrisk
premiumtothereturnsonthebuywritestrategy.Whiletheprimarydriverofthereturnsis
clearlytheRussell2000index,Exhibit15suggeststhatthevolatilitypremiumdrivesthe
outperformancewhichweseegeneratedbythebuywritestrategyovertheperiodinstudy.
Exhibit15and16provideasnapshotoftheaveragereturnattributionofthebuywrite
strategy.However,theydonotprovidedetailsonthedynamicnatureofthereturnattribution.
OnewouldexpectthatthecontributionoftheRussell2000tothereturnsofthebuywrite
wouldvarysignificantlyovertimeduetothevolatilityofthereturns.Likewise,onewould
expectthecontributionofthecallpositionpricedattherealizedvolatilitytoshowsimilar,
albeitnegativelycorrelated,movements.
Exhibit17a:1MonthATMBuywriteStrategyReturnAttributionTimeSeries
24MonthRollingReturnAttribution1MonthATM
4.0%
Rolling24MonthAverageMonthlyReturn
3.0%
2.0%
1.0%
0.0%
1.0%
2.0%
26|P a g e
Jan11
Aug10
Oct09
Mar10
May09
Jul08
Dec08
Feb08
Apr07
Sep07
Nov06
Jan06
Jun06
Aug05
Oct04
Mar05
May04
Jul03
BuyWriteTotalReturnATM
MidBid/AskCallatRealizedVol.ReturnATM
Trans.CostReturnATM
Dec03
Feb03
Apr02
Sep02
Nov01
Jan01
Jun01
Aug00
Oct99
Mar00
May99
Jul98
Dec98
Feb98
3.0%
Russell2000ReturnATM
Vol.Prem.ReturnATM
Exhibits17a,17band17cprovideagraphicalpresentationofthe24monthrollingaverage
returncontributions.TheExhibitsillustratethesignificantchangesinthecontributionofthe
excessimpliedvolatilityaswellasagradualdecreaseintheimpactoftransactioncosts.Forthe
1month2%OTMbuywrite,theaveragerollingreturnattributedtothevolatilitypremiumhas
graduallydecreasedovertimefromabout1%permonthatthestartoftheperiod.Infact,
duringthefinancialcrisis,theaveragereturnwasrelativelysteadyatabout0.3%permonth,
beforeonceagainturningpositiveattheendoftheperiod.
Exhibit17b:1Month2%OTMBuywriteStrategyReturnAttributionTimeSeries
24MonthRollingReturnAttribution1Month2%OTM
4.0%
Rolling24MonthAverageMonthlyReturn
3.0%
2.0%
1.0%
0.0%
1.0%
2.0%
27|P a g e
Jan11
Aug10
Oct09
Mar10
May09
Jul08
Dec08
Feb08
Apr07
Sep07
Nov06
Jan06
Jun06
Aug05
Oct04
Mar05
May04
Jul03
BuyWriteTotalReturn2%OTM
MidBid/AskCallatRealizedVol.Return2%OTM
Trans.CostReturn2%OTM
Dec03
Feb03
Apr02
Sep02
Nov01
Jan01
Jun01
Aug00
Oct99
Mar00
May99
Jul98
Dec98
Feb98
3.0%
Russell2000Return2%OTM
Vol.Prem.Return2%OTM
Exhibit17c:1Month5%OTMBuywriteStrategyReturnAttributionTimeSeries
24MonthRollingReturnAttribution1Month5%OTM
4.0%
Rolling24MonthAverageMonthlyReturn
3.0%
2.0%
1.0%
0.0%
1.0%
2.0%
Jan11
Aug10
Oct09
Mar10
May09
Jul08
Dec08
Feb08
Apr07
Sep07
Nov06
Jan06
Jun06
Aug05
Oct04
Mar05
May04
Jul03
BuyWriteTotalReturn5%OTM
MidBid/AskCallatRealizedVol.Return5%OTM
Trans.CostReturn5%OTM
Dec03
Feb03
Apr02
Sep02
Nov01
Jan01
Jun01
Aug00
Oct99
Mar00
May99
Jul98
Dec98
Feb98
3.0%
Russell2000Return5%OTM
Vol.Prem.Return5%OTM
Conclusion
WeexaminethereturnsonbuywritestrategiesontheRussell2000overtheperiodof
February1996toMarch2011,extendingtheanalysisofKapadiaandSzado[2007]by
approximatelyfiveyears.Overall,ourresultssuggestthatthebuywritestrategycan
outperformtheindexunderstandardperformancemeasures.Thisriskadjusted
outperformancealsoholdsduringtheunfavorablemarketconditionsofMarch2003toOctober
2007,wheretheRussell2000wassteadilytrendingupwards.Theoutperformanceislargely
limitedtowritingonemonthcallswhilethestrategyofwritingtwomonthcallstypically
underperformsboththeonemonthstrategyandtheindex.Toprovideeconomicinsightinto
theperformanceofthestrategy,weinvestigatethecomponentsofthereturns.Althoughthe
maindriverofthereturnistheunderlyingindex,bothtransactioncostsandtheoptionvolatility
riskpremium(definedastheimpliedvolatilitylesstherealizedvolatility)arecriticaltothe
performanceofthestrategy.OurresultsindicatethatiftheoptionwaswrittenattheBlack
Scholespriceassociatedwiththerealizedvolatility,thebuywritestrategywouldunderperform
theindexoveroursampleperiod.Itisclearlyevidentthatthemethodofexecutionofthe
28|P a g e
strategyaswellasthechoiceoftheoptionshasalargeimpactontheperformanceofthe
strategy.Inthislight,wehaveprovidedasomewhatconservativeanalysisofthebuywrite
strategy'sperformance,inthesensethatourimplementationdoesnotallowforanactive
selectionofthemoneynessortimetoexpirationofthecalls.Thereissomeevidenceinthe
literaturethatamoreactiveapproachtocallselectioncanresultinsignificantlyhigherabsolute
andriskadjustedreturns19.
19
See,forexample,RenickerandMallick[2005]andSzadoandSchneeweis[2010].
29|P a g e
Bibliography
Bakshi,Gurdip,andNikunjKapadia,DeltaHedgedGainsandtheNegativeVolatilityRisk
Premium,ReviewofFinancialStudies,16(2)(2003),pp.527566.
CallanAssociatesInc.,Profit/LossanHistoricalEvaluationoftheCBOES&P500BuyWriteIndex
Strategy,CallanAssociatesInc.,Oct,2006.
Feldman,Barry,andDhruvRoy,PassiveOptionsBasedInvestmentStrategies:TheCaseofthe
CBOES&P500BuywriteIndex,IbbotsonAssociates,July28,2004.
Gray,Tim.,BuywriteFunds:ABlastFromtheIndustry'sPast,NewYorkTimes,October15,
2006,MoneyandBusiness/FinancialDeskLateEditionFinal,Section3,Page6,Column1.
Hill,JoanneM.,VenkateshBalasubramanian,Krag(Buzz)Gregory,andIngridTierens,Finding
AlphaviaCoveredCallWriting,"FinancialAnalystsJournal,Sept/Oct2006,pp.2946.
Leland,HayneE.,BeyondMeanVariance:PerformanceMeasurementinaNonSymmetrical
World,FinancialAnalystsJournal,Jan/Feb1999,pp.2735.
Renicker,Ryan,andDevapriyaMallick,EnhancedCallOverwriting,LehmanBrothersGlobal
EquityResearch,Nov17,2005.
Stutzer,Michael,APortfolioPerformanceIndex,FinancialAnalystsJournal,May/June2000,
Vol.56,No.3:5261.
Szado,EdwardandThomasSchneeweis,LooseningYourCollarAlternativeImplementations
ofQQQCollars,JournalofTrading,Spring2010,Vol.5,No.2,pp.3556.
Whaley,RobertE.,ReturnandRiskofCBOEBuywriteMonthlyIndex,TheJournalof
Derivatives,Winter2002,pp.3542.
30|P a g e
Appendix:2MonthBuywriteStrategyPerformance
Thetwomonthbuywritestrategies,ingeneral,underperformtheRussell2000andthe
correspondingonemonthstrategies.Theunderperformanceholdsforboththeentireperiodas
wellasthefirstandlastsubperiods.ItisonlyintheshortersubperiodofMarch2003to
October2007thatthetwomonthstrategiesoutperformtheRussell2000indexandsomeof
thecorrespondingonemonthbuywritestrategiesbothfromanabsolutereturnandrisk
adjustedreturnbasis.Partofthegeneralunderperformancemaybeduetothefactthatthe
timevalueofthetwomonthcallsdecaysslowerthantheshortermaturityonemonthcalls
sincedecaytendstoincreaseasexpirationapproaches.Furthermore,Exhibit3aprovides
evidencethatthetwomonthcallsonaverageexperiencedlowerexcessimpliedvolatility(over
realizedvolatility)andlagerbidaskspreadsthanonemonthcalls(althoughtwomonth
strategiesrollthecallpositionshalfasfrequentlyasonemonthstrategies).Exhibits18through
21providesummarystatisticsfortwomonthbuywritestrategiesfortheentiresampleperiod
andthethreesubperiods.Inaddition,agraphicalpresentationofthetwomonthstrategy
performancerelativetotheunderlyingandtheonemonthbuywriteisprovidedinExhibit22.
Exhibit18:2MonthBuywriteStrategySummaryStatistics,FullPeriod
2MonthCallBuyWrite Russell
Feb1,1996toMar31,2011
2000TR
AnnualizedReturn
AnnualizedStandardDeviation
Skewness
ExcessKurtosis
CorrelationwithRUT
SharpeRatio
TreynorRatio
StutzerIndex
InformationRatiowithRUT
CAPMBeta
Jensen'sMonthlyAlpha
Leland'sBeta
Leland'sMonthlyAlpha
MeanMonthlyReturn
MedianMonthlyReturn
MinimumMonthlyReturn
MaximumMonthlyReturn
MaximumDrawdown
MaximumRunUp
%DownMonths
%UpMonths
NumberofMonths
31|P a g e
8.11%
21.06%
0.56
0.81
1.00
0.23
0.05
0.21
1.00
1.00
0.84%
1.68%
20.80%
16.51%
52.9%
226.2%
38%
62%
182
5%OTM 2%OTM
7.21%
17.80%
1.39
3.57
0.94
0.22
0.05
0.29
0.23
0.79
0.00%
0.81
0.01%
0.72%
1.74%
21.18%
10.66%
47.2%
193.7%
33%
67%
182
6.80%
16.30%
1.80
5.76
0.90
0.21
0.05
0.28
0.26
0.70
0.00%
0.72
0.02%
0.67%
1.71%
21.70%
10.23%
44.8%
178.4%
33%
67%
182
ATM
2%ITM
5%ITM
6.43%
15.01%
2.24
8.21
0.86
0.21
0.05
0.27
0.29
0.61
0.00%
0.64
0.02%
0.62%
1.46%
21.70%
8.12%
41.7%
174.0%
31%
69%
182
5.79%
14.06%
2.72
11.36
0.81
0.17
0.05
0.24
0.32
0.54
0.02%
0.57
0.04%
0.56%
1.31%
22.32%
8.14%
41.6%
150.7%
30%
70%
182
5.27%
12.71%
3.37
16.32
0.74
0.15
0.04
0.21
0.34
0.44
0.02%
0.48
0.04%
0.50%
1.03%
22.74%
8.27%
40.2%
139.5%
25%
75%
182
Exhibit19:2MonthBuywriteStrategySummaryStatistics,FavorablePeriod
2MonthCallBuyWrite Russell
Feb1,1996toFeb28,2003
2000TR
AnnualizedReturn
AnnualizedStandardDeviation
Skewness
ExcessKurtosis
CorrelationwithRUT
SharpeRatio
TreynorRatio
StutzerIndex
InformationRatiowithRUT
CAPMBeta
Jensen'sMonthlyAlpha
Leland'sBeta
Leland'sMonthlyAlpha
MeanMonthlyReturn
MedianMonthlyReturn
MinimumMonthlyReturn
MaximumMonthlyReturn
MaximumDrawdown
MaximumRunUp
%DownMonths
%UpMonths
NumberofMonths
32|P a g e
3.28%
21.83%
0.39
0.50
1.00
0.06
0.01
0.06
1.00
1.00
0.47%
0.91%
19.42%
16.51%
35.1%
93.3%
44%
56%
85
5%OTM 2%OTM
2.53%
18.12%
1.07
2.20
0.95
0.12
0.03
0.02
0.24
0.79
0.10%
0.80
0.10%
0.35%
1.29%
19.47%
10.00%
28.4%
59.2%
40%
60%
85
2.48%
16.66%
1.43
3.81
0.93
0.13
0.03
0.04
0.24
0.71
0.12%
0.72
0.12%
0.32%
1.21%
19.47%
8.42%
26.2%
54.4%
41%
59%
85
ATM
2%ITM
5%ITM
2.06%
15.39%
1.87
5.82
0.90
0.17
0.04
0.08
0.27
0.63
0.16%
0.64
0.16%
0.27%
1.21%
19.35%
7.63%
25.2%
54.1%
39%
61%
85
1.77%
14.42%
2.28
8.00
0.86
0.20
0.05
0.12
0.29
0.57
0.19%
0.58
0.19%
0.24%
0.98%
19.24%
6.90%
24.1%
52.7%
38%
62%
85
2.28%
12.95%
2.79
11.02
0.80
0.18
0.05
0.11
0.24
0.47
0.16%
0.49
0.16%
0.26%
0.89%
18.69%
6.08%
21.3%
52.7%
34%
66%
85
Exhibit20:2MonthBuywriteStrategySummaryStatistics,UnfavorablePeriod
2MonthCallBuyWrite Russell
Mar1,2003toOct31,2007
2000TR
AnnualizedReturn
AnnualizedStandardDeviation
Skewness
ExcessKurtosis
CorrelationwithRUT
SharpeRatio
TreynorRatio
StutzerIndex
InformationRatiowithRUT
CAPMBeta
Jensen'sMonthlyAlpha
Leland'sBeta
Leland'sMonthlyAlpha
MeanMonthlyReturn
MedianMonthlyReturn
MinimumMonthlyReturn
MaximumMonthlyReturn
MaximumDrawdown
MaximumRunUp
%DownMonths
%UpMonths
NumberofMonths
33|P a g e
20.92%
14.08%
0.05
0.09
1.00
1.27
0.18
1.09
1.00
1.00
1.68%
1.70%
6.84%
10.73%
10.8%
147.1%
30%
70%
56
5%OTM 2%OTM
19.68%
10.64%
0.38
0.21
0.92
1.56
0.24
1.44
0.27
0.69
0.30%
0.72
0.28%
1.55%
1.88%
5.35%
8.19%
7.4%
131.2%
21%
79%
56
18.24%
8.68%
0.57
1.20
0.84
1.75
0.29
1.58
0.39
0.51
0.43%
0.55
0.40%
1.44%
1.72%
5.18%
7.19%
5.2%
118.6%
18%
82%
56
ATM
2%ITM
5%ITM
17.20%
7.30%
0.60
2.10
0.75
1.94
0.37
1.72
0.43
0.39
0.53%
0.43
0.50%
1.35%
1.57%
4.57%
6.45%
4.6%
109.7%
16%
84%
56
16.01%
5.91%
0.45
3.63
0.65
2.19
0.48
1.93
0.49
0.27
0.61%
0.31
0.57%
1.26%
1.33%
4.07%
6.47%
4.1%
100.0%
14%
86%
56
12.78%
4.31%
0.57
4.05
0.50
2.26
0.65
1.97
0.67
0.15
0.54%
0.18
0.50%
1.02%
0.98%
3.48%
4.20%
3.5%
75.3%
7%
93%
56
Exhibit21:2MonthBuywriteStrategySummaryStatistics,FinancialCrisis
2MonthCallBuyWrite Russell
Nov1,2007toMar31,2011
2000TR
AnnualizedReturn
AnnualizedStandardDeviation
Skewness
ExcessKurtosis
CorrelationwithRUT
SharpeRatio
TreynorRatio
StutzerIndex
InformationRatiowithRUT
CAPMBeta
Jensen'sMonthlyAlpha
Leland'sBeta
Leland'sMonthlyAlpha
MeanMonthlyReturn
MedianMonthlyReturn
MinimumMonthlyReturn
MaximumMonthlyReturn
MaximumDrawdown
MaximumRunUp
%DownMonths
%UpMonths
NumberofMonths
1.99%
26.78%
0.58
0.03
1.00
0.03
0.01
0.03
1.00
1.00
0.46%
3.01%
20.80%
15.46%
52.0%
123.0%
39%
61%
41
5%OTM 2%OTM
1.18%
23.90%
1.38
2.33
0.92
0.00
0.00
0.13
0.19
0.82
0.06%
0.84
0.06%
0.35%
2.33%
21.18%
10.66%
47.2%
97.3%
34%
66%
41
1.25%
22.40%
1.66
3.66
0.89
0.01
0.00
0.12
0.20
0.74
0.05%
0.76
0.05%
0.32%
2.36%
21.70%
10.23%
44.8%
89.1%
37%
63%
41
ATM
2%ITM
5%ITM
1.78%
20.87%
1.98
5.11
0.86
0.03
0.01
0.14
0.17
0.66
0.00%
0.69
0.01%
0.34%
2.34%
21.70%
8.12%
41.7%
81.4%
37%
63%
41
1.05%
19.95%
2.30
6.86
0.81
0.00
0.00
0.10
0.23
0.60
0.05%
0.63
0.06%
0.26%
1.86%
22.32%
8.14%
41.6%
70.9%
37%
63%
41
1.70%
18.64%
2.77
9.70
0.74
0.03
0.01
0.13
0.20
0.51
0.01%
0.54
0.01%
0.30%
1.47%
22.74%
8.27%
40.2%
62.7%
29%
71%
41
Exhibit22:2MonthBuywriteStrategyGrowthof$100,FullPeriod
2%OTMBuyWriteGrowthof$100
$400
$350
$300
$250
$200
$150
$100
$50
RUTTR
34|P a g e
2Month2%OTM
Feb11
Aug10
Feb10
Feb09
Aug09
Feb08
Aug08
Feb07
Aug07
Feb06
Aug06
Feb05
Aug05
Feb04
1Month2%OTM
Aug04
Feb03
Aug03
Feb02
Aug02
Aug01
Feb01
Feb00
Aug00
Aug99
Feb99
Feb98
Aug98
Feb97
Aug97
Feb96
Aug96
$0